by Barry Vinocur
Illustration © Timothy John/SIS

Sometimes you just can’t catch a break. To wit, after enduring the worst two-year slump in the REIT industry’s 40-year history (without question 1998 and 1999 were the roughest back-to-back years since real estate funds came on the scene in the mid-1980s), real estate fund managers got what they had been hoping for last year - in spades. Heading into 2000, most fund managers forecast REITs would deliver total returns in the 12 to 15 percent range; the sort of returns they suggest investors should expect from the stocks most years. In fact, REITs did better than that - much better.

As we note in this issue (see page 46), the Morgan Stanley REIT Index (ticker is RMS), which excludes healthcare REITs, posted a 26.8 percent total return last year, besting the Standard & Poor’s 500-Stock Index, which ended the year down 9.1 percent. It also outpaced the Nasdaq Composite, which had its worst year ever chalking up a negative 38.8 percent total return, and outperformed the Russell 2000, which finished down 3 percent for the year.

The only sector that didn’t get trounced by REITs last year was another traditional safe haven for income-focused investors: utilities. Like REITs, utilities had a disappointing 1999, finishing in the red, down 8.9 percent. But the sector came roaring back in 2000, with the S&P Utility Index posting an eye-popping 59.5 percent total return.

Despite those strong returns, fund managers didn’t see the assets in their funds swell. According to AMG Data Services in Arcata, California, after experiencing net redemptions of roughly $1.3 billion in 1998 and another $1.3 billion in 1999, dedicated real estate funds saw net inflows last year of only $364 million. (At our press deadline, AMG was finalizing its numbers. And, two fund groups had still not reported their year-end figures.) Though inflows are preferable to the alternative, fund managers were stunned that more money didn’t come into the sector through their funds. Said one fund manager, "We didn’t expect that flows would turn on a dime. But when we saw our mid-year 2000 numbers, and we looked around and saw where we stood vs. the broader market, generally, and other fund categories, specifically, we figured it was just a matter of time until the flows started. It never happened!"

There’s no way to know why investors didn’t turn to real estate funds last year. Some industry veterans speculated that investors were reluctant to pour money into a sector that had disappointed them so badly the two prior years. Others suggested it took a while for investors to realize the Nasdaq wouldn’t snap back as it had done before.

Whatever was responsible for the lack of significant inflows into real estate funds last year, a lot of fund managers think this year will be different. Several said they expect flows to pick up as investors who focus on yield back away from utilities.

Sam Lieber, whose Alpine Funds group offers several real estate funds, said he expects that the combination of attractive yields, reasonable valuations, and the prospect of 12 to 15 percent total returns will grab the attention of financial advisors and investors in 2001. Like others, Lieber also is counting on financial advisors and investors who abandoned asset allocation during dot-com mania to return to the asset-allocation fold. "Most advisors who practice asset allocation agree that allocating some portion of portfolios to real estate makes sense." Lieber also pointed out that institutions are increasingly viewing property-linked stocks as a suitable proxy for owning buildings outright. "Over the past several years, a number of large pension funds have increased their investments in REITs and other property-linked stocks." REITs, he added, not only provide real estate exposure, but also offer liquidity. "It’s easier to close out a position in one of the large, liquid REITs than it is to sell a shopping mall or an office building," Lieber stressed.

Some industry veterans believe the sector may benefit this year from the increasing popularity of so-called ETFs, or exchange-traded funds. Last year, Barclays rolled out a series of ETFs tied to well-known indices, such as the S&P 500. Barclays calls the products "iShares" and has a Website (www.ishares.com) that not only provides information on iShares, generally, but also specific information on each ETF.

Barclays’ iShares Dow Jones Real Estate Index Fund (ticker is IYR) was launched on June 12, 2000. At the end of last year, the fund’s top 10 holdings (and weightings) were: Equity Office (9.7 percent); Equity Residential (7.1 percent); ProLogis (3.6 percent); Simon Property Group (3.3 percent); Spieker Properties (3.2 percent); AvalonBay Communities (3.1 percent); Archstone Communities (3.1 percent); Apartment Investment & Management Co. or AIMCO (3.1 percent); Duke-Weeks (2.9 percent); and Kimco Realty (2.5 percent).

As we were going to press, we learned that Barclays is teaming up on a new ETF with Cohen & Steers Capital Management, which specializes in property-linked stocks and already offers a diverse product line that includes open-end funds, two closed-end funds, as well as institutional separate accounts. The fund will be tied to Cohen & Steers Realty Majors (see Newsline in this issue, which begins on page 6), an index (ticker is RMP) that Cohen & Steers launched at the end of 1998. Last year, Cohen & Steers Realty Majors posted a 31.0 percent total return. Barclays’ iShares Cohen & Steers Realty Majors Portfolio is scheduled to begin trading (ticker is ICF) on January 26, 2001.

In the end, real estate fund managers seem to be pinning their hopes - at least in part - on a return to something approaching normality. Investors who thought the prospect of 10 to 12 percent annual returns sounded pretty tame in the dot-com era may long for that sort of stability. If that proves to be the case, they stressed, fund flows could pick up substantially in 2001.

Funds on Parade
When the bell rang on December 29 to end trading for 2000, real estate fund managers were feeling good. According to data supplied to us by Lipper Inc., the "average" real estate fund (see page 49) posted a 25.2 percent total return in 2000, outperforming not only the broader market benchmarks by a wide margin, but also the average diversified stock fund.

Of the more than five dozen real estate funds tracked by Realty Stock Review (Property’s sister publication), nearly 60 percent outperformed the Morgan Stanley REIT Index last year. (Unlike Lipper and Morningstar, Realty Stock Review doesn’t count each share class as a separate fund.) The table at the bottom of page 50 tracks the assets of a representative sample of real estate funds. (Realty Stock Review totals the assets of all share classes and uses that data to track fund growth over time.) Changes in fund assets incorporate not only fund flows but changes that occur as a result of rising stock prices. The top five performing real estate funds in 2000 were: (1) Security Capital US Real Estate Shares (35.8 percent total return); (2) SSgA (State Street Global Advisors) Real Estate Equity (34.8 percent total return); Delaware Pooled Trust (32.5 percent total return); CRA Realty Shares (32.3 percent total return); and Alpine Realty Income and Growth Fund (32 percent total return). Bringing up the rear (domestic stock funds only) last year were: FBR Realty Fund (0.23 percent total return); Cohen & Steers Special Equity, which in 1999 led the pack, outperforming the S&P 500 (3.4 percent total return); Fremont Real Estate Securities (11.2 percent); Longleaf Partners Realty (14.8 percent total return); and Prudential Real Estate (17.3 percent total return).

Shifting Focus
Though investors understandably focus on annual returns, our long-held view has been that investors should look beyond total returns to risk-adjusted returns. Though some pundits argue that an investor "cannot eat risk-adjusted (nor relative) returns," the fact remains that risk matters.

Just as a passenger would want to know that the reason one car service promises to get from point A to point B in half the time of another service is because the "faster" service travels at 120 mph vs. 60 mph, investors should want to know how much risk a fund manager takes.

Rather than focusing on risk-adjusted returns, however, some fund managers over the years have chosen to emphasize their funds’ "low betas." In fact, if you compare the betas of real estate funds vs. the beta for the Standard & Poor’s 500-Stock Index, you find an extraordinarily low beta. But those funds also have R2s that are (or approach) zero (see page 86 for our Glossary of Terms) when calculated based on the S&P 500.

In his book, Wealth Management: The Financial Advisor’s Guide to Investing and Managing Client Assets" (Irwin Professional Publishing, 1997), certified financial planner Harold Evensky addresses the use of beta and its interrelationship with R2, or the coefficient of determination.

"It’s of no value to measure the risk of a portfolio by its beta, if the beta is based on an inappropriate market," Evensky wrote. He added that his firm looks for another "best fit index" if R2 falls below 75.

What do the low betas and R2s of real estate funds vs. the S&P 500 tell you? Put simply, that at least over the last several years, there’s been a very low - if any - correlation between the performance of the S&P 500 and the performance of real estate funds. (As you would expect, the R2 of the Vanguard 500 Index Trust is 100, which tells you that all of that fund’s risk can be explained by the risk of the S&P 500-Stock Index). Put another way, the risk associated with real estate funds cannot be explained by the S&P 500’s risk. That doesn’t imply, however, that property-linked stocks, or the funds that invest in them, are "low risk."

When analyzing domestic real estate funds, Morningstar uses the Wilshire REIT Index as the "best fit index." The table on page 51 shows the "best fit betas" and "best fit R2s" for the roughly 40 real estate funds Morningstar has sufficient data points for to provide the analysis.

To get a better handle on risk when analyzing real estate funds, you should look at standard deviation, as well as Sharpe ratios (see page 51), which is calculated by subtracting the risk-free (that is, T-bill) rate from a portfolio’s total return and then dividing that number by the portfolio’s standard deviation. The resulting fraction can be thought of as return per unit of risk. The higher a portfolio’s Sharpe ratio, the better that portfolio’s risk-adjusted performance.

Interestingly, two funds that finished at the top of the list in terms of performance last year - Security Capital US Real Estate, which finished first, and Delaware Pooled Trust, which finished third - also ranked high in terms of their Sharpe ratios. Keep in mind, however, that not all funds are included in the Sharpe ratio listing, because the funds may not have been around long enough for Morningstar to have sufficient data points to provide Sharpe ratios for those funds.

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